The Diversification Rule

September, 2023
The Diversification Rule

The Variable Life Insurance Diversification Requirement is a regulatory rule established by the U.S. Securities and Exchange Commission (SEC) that requires variable life insurance policies to invest in a diversified pool of securities.1

Under the SEC's rule, variable life insurance policies must invest in a range of securities, which typically includes stocks, bonds, and other types of investments, to reduce the risk of loss to policyholders. The rule applies to private placement life insurance (PPLI) and requires that no more than 55% of the value of the total assets of the account is represented by any one investment with increasing thresholds for additional investments:  no more than 70% of the value for two investments; no more than 80% of the value for three investments; and, no more than 90% of the value for four investments.

Specific to each Insurance Dedicated Fund (IDF), the Treasury Regulations contain a “look-through” rule for partnerships that allow a segregated account to look through an IDF to its underlying investments for purposes of satisfying the Test. This differs from the application of the test for a Separately Managed Account (SMA) where the Test is satisfied based on the number of assets and asset value held within the SMA.  Given that most SMAs created by professional managers have dozens, if not hundreds of investments, the Test is easily met.

In other words, a policyholder may choose one IDF and meet the Test as long as the IDF itself has at least five different investments meeting the threshold asset value percentages.  When a SMA is used, there is not a look-through and the policy must have at least five, individual investments and meet the threshold asset percentages.

Proper diversification must be met by the first anniversary of the policy (a longer period is permitted for investments made into specific classes of real estate). At the end of each quarter, diversification is tested and is confirmed by the investment manager to the insurer.  If a policy fails a quarterly diversification test, there is a 30-day cure period.  

If a failure of the diversification test is not cured, the policy may be deemed to not be life insurance and all the tax benefits of life insurance lost.  This could result in the retroactive assessment of taxation at ordinary rates, plus fees and interest, on any investment growth in the separate account.

It is important to note that a policy does not fail the diversification test if individual investments gain or lose value without the actions of the policyholder or investment manager making investment purchases, sales or trades.

In addition to the diversification requirement, the SEC also requires that variable life insurance policies provide detailed information about the investment options available within the policy, as well as the risks and fees associated with each option.

By requiring variable life insurance policies to be diversified, the SEC aims to protect policyholders from the risks associated with investing in a single security or issuer. The rule also helps to ensure that variable life insurance policies provide a level of investment risk that is appropriate for the policyholder's investment objectives and risk tolerance.

Please reach out anytime.

  1. 1 Treasury Regulations §1.817-5

Contact Us

Thank you! Your submission has been received!

Oops! Something went wrong while submitting the form